By Timothy J. Keating
Shortly after the Sarbanes-Oxley Act of 2002 was implemented, it suddenly became very unfashionable to be public—particularly for smaller companies. Out went the emerging growth underwriters of the 1990s (Montgomery, Robertson Stephens, Hambrecht & Quist, to name a few), and in came the leveraged buyout artists to take companies to the promised land of being private…before going public again. So now that enough time has passed, how has it all worked out? That depends. If you were a private company or a limited partner in a private equity fund, the track record has been mixed, at best. If, however, you were a private equity sponsor, chances are that in the era of cheap money that recently ended (and by charging fees for every activity imaginable) you probably did pretty well.
Because of the enormous amounts of leverage associated with private equity investments, along with the lack of a benchmark index for comparison purposes, it can be extremely difficult to accurately evaluate investment performance. The goal of this white paper is to provide financial advisers and their investor clients with a framework to effectively assess potential private equity fund investment opportunities that can play a valuable, return-enhancing role in a well-constructed portfolio. We believe that a value-added private equity fund should possess the following three key characteristics: (i) an identifiable source of “alpha” [see related white paper on this subject]; (ii) the ability to add value to portfolio companies in ways other than through pure financial engineering; and (iii) the use of little or no leverage. There are gems to be found in the world of private equity—the trick is knowing what to look for and where to mine.
Conclusion
Properly selected investments in private equity do generate superior returns relative to other equity alternatives, though often with higher levels of risk and illiquidity. As with any mutual fund or other actively managed financial product, the challenge for advisers is how to identify these top-quartile funds. The three key characteristics that a top-quartile fund should possess are: (i) an identifiable source of “alpha”; (ii) the ability to add value to portfolio companies in ways other than purely through financial engineering; and (iii) the use of little or no leverage. To the extent that an investor can participate in a publicly traded private equity vehicle, the illiquidity risk can be either mitigated or eliminated. There are gems to be found in the world of private equity—the trick is knowing what to look for and where to mine.
